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CAPITAL BUDGETING CASH FLOWS & RISK

The questions for Module 2.3 Capital Budgeting Cash Flows are from Chapter 8 of Gitman, Principles of
Managerial Finance, 6e, Pearson Education, Sydney, 2011. The questions are available to you via Module
2.3 of the 125.230 Stream site.

SOLUTIONS TO GITMAN PROBLEMS: 8.6, 8.9, 8.11, 8.12, 8.17, 8.20, 8.21, 8.23, 8.28, 8.30, 8.36, 8.44

8-6 LG 3: Expansion versus replacement cash flows

a. Year Relevant Cash Flows

Initial investment ($28,000)

1 4,000
2 6,000
3 8,000
4 10,000
5 4,000

b. An expansion project is simply a replacement decision in which all cash flows from the old asset are zero.

8-9 LG 3: Sunk costs and opportunity costs

a. Sunk cost – since the funds for the tooling had already been expended and would not change no matter
whether the new technology would be acquired or not.

b. Opportunity cost – the development of the computer programs can be done without additional expenditures
on the computers; however, the loss of the cash inflow from the leasing arrangement would be a lost
opportunity to the firm.

c. Opportunity cost – the company will not have to spend any funds for floor space but the lost cash inflow
from the rent would be a cost to the firm.

d. Sunk cost – the money for the storage facility has already been spent and no matter what decision the
company makes there is no incremental cash flow generated or lost from the storage building.

e. Opportunity cost – forgoing the sale of the crane costs the firm $180,000 of potential cash inflows.

8-11 LG 4: Book value

Installed Accumulated Book

Asset Cost Depreciation Value
A $ 950,000 $570,000 $380,000
B 40,000 13,333 26,667
C 96,000 76,800 19,200
D 350,000 70,000 280,000
E 1,500,000 1,071,429 428,571

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8-12 LG 4: Book value and tax calculations

Book value = $175,000 – $124,250 = $50,750

Recaptured depreciation = $110,000 – $50,750 = $59,250

8-17 LG 4: Change in net working capital calculation

a. Current assets Current liabilities

Cash $ + 15,000 Accounts payable $ + 90,000
Accounts receivable + 150,000 Accruals + 40,000
Inventory – 10,000
Net change $ 155,000 $ 130,000

Net working capital = Current assets – Current liabilities

Change in NWC = $155,000 – $130,000 = $25,000

b. Analysis of the purchase of a new machine reveals an increase in net working capital. This increase should
be treated as an initial outlay and is a cost of acquiring the new machine.

c. Yes, in computing the terminal cash flow, the net working capital increase should be reversed because the
extra working capital will be recovered at the end of the project.

8-20 LG 4: Calculating initial investment

Existing Asset
Cost 30,000
Less: Accumulated depreciation 18,000
Book value 12,000
Sale price 20,000
Profit on sale 8,000

Tax on profit (30%) 2,400

Cash flow on sale $20,000 – tax $2,400 = $17,600

New Asset
Cost 55,000
Less: Cash flow on sale 17,600
Initial investment 37,400

8-21 LG 4: Calculating initial investment

Initial investment = Purchase price + Installation costs

– After-tax proceeds from sale of old asset
+ Change in net working capital

= $55,000 + $7,500 – $35,000 + $11,250 + $2,000

= $40,750

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8-23 LG 4: Initial investment – basic calculation

Installed cost of new asset =

Cost of new asset $35,000
+ Installation Costs 5,000
Total installed cost (depreciable value) $40,000
- After-tax proceeds from sale of old asset =
Proceeds from sale of old asset* ($25,000)
+ Tax on sale of old asset 5,100
Total after-tax proceeds of old asset ($19,900)
Initial investment $20,100

 ($20,000  3) 
*Book value of existing machine = $20,000 –   = $8,000
 5 

Recovered depreciation = $20,000 – $8,000 = $12,000

Capital gain = $25,000 – $20,000 = $5,000

Tax on recovered depreciation = $12,000 × (0.30) = $3,600

Tax on capital gain = $ 5,000 × (0.30) = 1,500
Total tax = $5,100

Note: The question indicates that capital gains are taxable, so in that context, the answer is correct. Note, in NZ,
capital gains are not taxable, so the tax on capital gain would be zero (not $1500).

8-28 LG 5: Incremental operating net cash inflows

Cost savings $20,000

less Depreciation (60,000 / 5) 12,000
Profit before tax 8,000
less Tax (30%) 2,400
Profit after tax 5,600
add back Depreciation 12,000
Incremental cash flow 17,600

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8-30 LG 5: Personal finance: Incremental operating cash flows

Richard and Linda Thomson

Incremental Operating Cash Flows
Replacement of John Deere Riding Mower
Year 1 Year 2 Year 3 Year 4 Year 5
Savings from new and improved mower $500 $ 500 $500 $500 $500
Annual maintenance cost 120 120 120 120 120
Depreciation* 360 360 360 360 360
Savings (loss) before taxes 20 20 20 20 20
Taxes (30%) 6 6 6 6 6
Savings (loss) after taxes 14 14 14 14 14
Depreciation 360 360 360 360 360
Incremental operating cash flow $374 $ 374 $374 $374 $374

Depreciation Schedule
Year Base Depreciation at 20%
Year 1 $1,800 $360
Year 2 1,800 360
Year 3 1,800 360
Year 4 1,800 360
Year 5 1,800 360

8-36 LG 6: Terminal cash flow – replacement decision

Book value of new machine after 4 years

= [$230,000 – ($230,000 × 4/5)] = $46,000

New Old
Proceeds from sale $75,000 $15,000
less Book value 46,000 0
Gain on sale of asset 29,000 15,000
Tax to pay at 30% (8,700) (4,500)

Proceeds from sale 75,000 15,000

less Tax to pay (8,700) (4,500)
After-tax proceeds 66,300 10,500

After-tax proceeds (new machine) 66,300

less After-tax proceeds forgone (old
machine) (10,500)
Plus recovery of working capital 25,000
Incremental terminal cash flow 80,800

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8-44 Ethics problem

Alex is correct in stating that the total cash flows over the project remain the same, but he has now changed
total project life. One of the key issues for all businesses is the timing of cash flows. Getting the timing
wrong can be the difference between a viable and non-viable project.

On a net present value basis, the value of Alex’s revised cash flow schedule will be higher (as the cash flows
all occur sooner) than the value of the actual cash flows which involve a zero return in the first year. This
could lead to accepting a project that, with access to the actual cash flows, might have been rejected. Alex
is fooling himself, his employers and investors, if he believes that the timing of cash flows is irrelevant.
Alex should consider how objective the revised data are, and how truthful he is being with his revised figures.
He should consider who might benefit and who might suffer if his revised figures are accepted as being
realistic. At the end of the day, Alex has to consider how professional his behaviour is likely to be seen
considering the responsibility he has to other parties.

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CHAPTER 12

SOLUTIONS TO PROBLEMS: P12-1, 12-9, 12-12, 12-14, 12-16, 12-18, 12-21

P12-1 Recognizing risk (LG 1; Basic)

a. and b.
Project Risk Reason
A Low The cash flows from the project can be easily determined because this
expenditure is all outflows. The amount is also relatively small.
B Medium The nature of the industry will compel Spin Corp. to make this expenditure
to remain competitive. The risk is only moderate because the firm already
has clients in place to use the new technology.
C Medium Because the firm is only preparing a proposal, their commitment at this
time is low. However, the $450,000 is a large sum of money for the
company, and it will immediately become a sunk cost.
D High Although this purchase is in the industry in which Spin Corp. normally
operates, they are encountering a large amount of risk. The large
expenditure, the competitiveness of the industry, and the political and
exchange risk of operating in a foreign country add to the uncertainty.
Note: Other answers are possible depending on student assumptions. Too little information is given
about the firm and industry to establish a definitive risk analysis.

P12-9 Risk-adjusted discount rates: Basic (LG 4; Intermediate)

a. Project X
Number of years = 4, I = 13.5;
Cash flows: CF0 = −$16,500, CF(1-4) = $5,500
Solve for NPV = -$308.92
n
CFt
NPV = – CF
(1 + r)t
t=1

5,500 5,500 5,500 5,500

NPV = -16,500+ + + + = −$308.92
1.13 1.13 1.13 1.13

All other NPV calculations should be similar to the above, using the firm cost of capital of
13.5%.

Project Y
Number of years = 4, I = 13.5;
Cash flows: CF0 = −$13,000, CF1 = $6,500, CF2 = $4,500, CF3 = $5,200, CF4 = $2,200,
Solve for NPV = $1,102.17

Project Z
Number of years = 4, I = 13.5;
Cash flows: CF0 = −$21,000, CF1 = $5,000, CF2 = $6,500, CF3 = $7,500, CF4 = $11,500,
Solve for NPV = $510.17

Project Y should be accepted as it has the highest positive NPV of $1,102.17.

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b. RADRj = RF  [RIj × (r − RF)]

RADRx = 10  [1.7 × (13.5 − 10)] = 15.95%
RADRy = 10  [1 × (13.5 − 10)] = 13.5%
RADRz = 10  [0.4 × (13.5 − 10)] = 11.4%

c. Project X
Number of years = 4, I = 15.95;
Cash flows: CF0 = −$16,500, CF(1-4) = $5,500
Solve for NPV = −$1,094.53
n
CFt
NPV = – CF
(1 + r)t
t=1

5,500 5,500 5,500 5,500

NPV = -16,500+ + + + = −$1,094.53
1.1595 1.1595 1.1595 1.1595

All other NPV calculations should be similar to the above, using the project RADR..

Project Y
Number of years = 4, I = 13.5;
Cash flows: CF0 = −$13,000, CF1 = $6,500, CF2 = $4,500, CF3 = $5,200, CF4 = $2,200,
Solve for NPV = $1,102.17

Project Z
Number of years = 4, I = 11.4;
Cash flows: CF0 = −$21,000, CF1 = $5,000, CF2 = $6,500, CF3 = $7,500, CF4 = $11,500,
Solve for NPV = $1,618.32

Project Z should be accepted as it has the highest positive NPV of $1,618.32.

d. The NPV calculations in part (a) indicates that Project Y should be accepted, while the NPV
calculations in part c indicate that Project Z should be accepted. It is recommended to accept
Project Z as the NPV calculations using the RADR approach takes risk into account.

P12-12 Risk-adjusted rates of return using CAPM (LG 4; Challenge)

a. RADRj = RF  [RIj × (r ‒ RF)]
RADRRoots = 6.5%  [1.4 × (10% ‒ 6.5%)] = 11.4%
RADRBranches = 6.5%  [1.6 × (10% ‒ 6.5%)] = 12.1%

Investment Roots
Number of years = 5,
Cash flows:CF0 = ‒$82,000, CF(1-4) = $35,000,
Set I = 11.4
Solve for NPV = $25,664.70

35,000 1
NPV = -82,000+ × 1- = $25,664.70
. 114 (1+.114)

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Investment Branches
Number of years = 4,
Cash flows:CF0 = ‒$85,000, CF1 = $24,000, CF2 = $34,000, CF3 = $42,000, CF4 = $44,000,
Set I = 12.1
Solve for NPV = $21,143.70

24,000 34,000 42,000 44,000

NPV = -85,000+ 1 + 2 + 3 + = $21,143.70
1.121 1.121 1.121 1.1214

b. Both investments are acceptable as both have positive NPV. However, the investments are
mutually exclusive; therefore, only one can be accepted. Recommendation: investment Roots
should be accepted as the NPV is higher than that for investment Branches.

P12-14 Unequal lives: ANPV approach (LG 5; Intermediate)

a. Machine A
Project cost (CF0)  −$85,000, cash inflows (CF1-6)  $27,000; number of years = 6;
and cost of capital  15%.
Solve for NPV  $17,181.03
27,000 1
NPV = -85,000 + × 1- = $17,181.03
. 15 (1+.15)
Machine B
Cash flows: CF0 (project cost)  −$68,000, CF1  $23,000, CF2  $33,000, CF3  $33,000,
CF4  $33,000; and cost of capital  15%,
Solve for NPV  $17,518.63
23,000 33,000 33,000 33,000
NPV = -68,000+ 1 + 2 + 3 + 4 = $17,518.63
1.15 1.15 1.15 1.15

Machine C
Project cost (CF0)  −$98,500, number of years = 5, cost of capital  15%
Cash inflows (CF1-5)  $35,000
Solve for NPV  $18,825.43
35,000 1
NPV = -98,500 + × 1- = $18,825.43
. 15 (1+.15)

Rank Machine
1 C
2 B
3 A
b. Machine A
Number of years  6, cost of capital  15%, PV  $17,181.03
Solve for ANPV = NPV/PVIFA,
1 1
Where PVIFA = × 1- (1+r)n
r

17,181.03 17,181.03
ANPV = = = 4,539.86
1 1 3.78448
× 1−
. 15 (1.15)

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Machine B
Number of years  4, cost of capital  15%, PV  $17,518.63
Solve for ANPV = NPV/PVIFA

17,518.63 17,518.63
ANPV = = = 6,136.17
1 1 2.85498
× 1−
. 15 (1.15)

Machine C
Number of years  5, I  15%, PV  $18,825.43
Solve for ANPV = NPV/PVIFA

18,825.43 18,825.43
ANPV = = = 5,615.92
1 1 3.35216
× 1−
. 15 (1.15)

Rank Machine
1 B
2 C
3 A

c. Machine B should be acquired because it offers the highest ANPV. The ranking without
consideration of the difference in project lives puts Machine C on top.

P12-16 Unequal lives: ANPV approach (LG 5; Intermediate)

a. Sell
Cash flows: project cost (CF0)  −$230,000, CF1  $200,000, CF2  $240,000, CF3  $190,000;
and cost of capital  15%. Solve for NPV  $250,315.61

200,000 240,000 190,000

NPV = -230,000+ 1 + 2 + 3 = $250,315.61
1.15 1.15 1.15

License
Cash flows: project cost (CF0)  −$230,000, CF1  $250,000, CF2  $100,000, CF3  $90,000,
CF4  $65,000, CF5  $55,000; and cost of capital  15%.
Solve for NPV  $186,690.81
250,000 100,000 90,000 65,000 55,000
NPV = -230,000+ 1 + 2 + 3 + 4 + 5
= $186,690.81
1.15 1.15 1.15 1.15 1.15

Manufacture
Cash flows: project cost (CF0)  −$440,000, CF1  $195,000, CF2  $195,000, CF3  $195,000,
CF4  $195,000, CF5  $195,000, CF6  $195,000.
Cost of capital  15%. Solve for NPV  $297,974.13

195,000 1
NPV = -440,000 + × 1- = $297,974.13
. 15 (1+.15)

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Rank Alternative
1 Manufacture
2 Sell
3 License
b. Sell
Number of years 3, cost of capital  15%, PV  $
Solve for ANPV (annual payment equivalent project NPV)  $109,632.47

Solve for ANPV = NPV/PVIFA,

1 1
Where PVIFA = × 1- (1+r)n
r

$250,315.61 250,315.61
ANPV = = = 109,632.47
1 1 2.28323
× 1−
. 15 (1.15)

License
Number of years 5, cost of capital  15%, PV  $186,690.81. Solve for ANPV  $55,692.77

Solve for ANPV = NPV/PVIFA

186,690.81 186,690.81
ANPV = = = 55,692.77
1 1 3.35216
× 1−
. 15 (1.15)

Manufacture
Number of years 6, cost of capital  15%, PV  $297,974.13. Solve for ANPV  $78,735.76

Solve for ANPV = NPV/PVIFA

297,974.13 186,690.81
ANPV = = = 78,735.76
1 1 3.78448
× 1−
. 15 (1.15)

Rank Alternative
1 Sell
2 Manufacture
3 License
c. Both parts (a) and (b) indicate different alternatives (NPV Manufacture, ANPV Sell). The
recommendation is to sell, based on the highest ANPV. Comparing the NPVs of projects with unequal
lives gives an advantage to those projects that generate cash flows over a longer period.

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P12-18 Real options and the strategic NPV (LG 6; Intermediate)

a. Value of real options = Value of abandonment + Value of expansion + Value of delay
Value of real options = (0.25 × €15,000,000) + (0.40 × €25,000,000) + (0.05 × €100,000,000)
Value of real options = €18,750,000
NPVstrategic = NPVtraditional + Value of real options = −10,000,000 + 18,750,000 = €8,750,000
b. Due to the added value from the options, Dave should recommend accepting the proposed
expansion.
c. In general, this problem illustrates that by recognizing the value of real options, a project that
would otherwise be unacceptable (NPVtraditional < 0) could be acceptable (NPVstrategic > 0). It is
thus important that management identify and incorporate real options into the NPV evaluation.

P12-21 Ethics problem (LG 4; Challenge)

Students’ answers will vary. Most students may argue that the appropriate goal should be the
reduction of overall pollution levels, and that the additional cost has benefits which in the long-term
would be beneficial for the community as a whole. They may also state that the cost of the filtering
solution is known, while the exact cost of fines might be higher. Some students, on the other hand,
might argue that the company should take the risk and choose to pay the fines in order to allow the
polluting firm to meet legal obligations in the most cost-effective manner, thus improving the bottom
line for the company and investor.

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